3.7. Cash flow
Syllabus Content
- The difference between profit and cash flow
- The working capital cycle
- Cash flow forecasts
- The relationship between investment, profit and cash flow
- The following strategies for dealing with cash flow problems: reducing cash outflows, improving cash inflows & seeking additional finance
The difference between cash flow and profit
There are many types of cash transactions. They can form distinguished by their purpose, their form (how they are implemented) and their frequency.
Cash flows and Profit
1. Cash may be obtained from a transaction which has nothing to do with profit or loss. E.g. issue of shares for cash or loan stock for cash has no immediate effect on profit but is obviously a source of cash. Similarly, an increase in bank overdraft provides a source of cash for payments but it is not reported in the income statement.
2. Cash may be paid for the purchase of non-current assets, but the charge in the income statement is depreciation which is only a part of an asset’s cost.
3. When a non-current asset is sold there is a profit or loss on sale equal to the difference between the sale proceeds and the net book value of the asset in the statement of financial position at the time it is sold.
4. Cash flows also differ from trading profits due to changes in the amount of the company’s inventories, receivables and payables between the start and end of a period.
Task 1: Indicate which of the following transactions represent cash inflow, cash outflow or neither
(a) Payment of dividends
(b) Providing for depreciation
(c) Purchase of fixed assets
(d) Payment of tax
(e) Sales on credit
(f) Sale of fixed asset
The difference between profit and cash flow has important implications.
1. If a company is profitable but short of cash, one reason could be an increase in the other elements of working capital. Instead of seeking credit from a bank to finance the growth in working capital, management may consider whether operational cash flows could be improved by squeezing working capital.
● Reducing receivables (Trade Debtors)
● Reducing inventories (Stocks)
● Taking more trade credit from suppliers
Better control over working capital could remove the need to borrow
2. If a company is making losses, it could try to maintain a positive operational cash flow by taking more credit (i.e. increasing its payables and so decreasing working capital).
Difference between cash flow and profit
Working Capital Cycle
Working capital is the capital available for conducting the day-to-day operations of an organization; normally the excess of current assets over current liabilities.
The current assets of a business can be subdivided into permanent current assets (core levels of inventory and receivables) and fluctuating current assets which vary from period to period.
Working Capital Management
This is ensuring that sufficient liquid resources are maintained. This involves achieving a balance between the requirement to minimize the risk of insolvency and the requirement to maximize the return on assets.
a) A business pursuing an aggressive working capital policy will hold minimal cash and inventories and use short-term financing to fund both permanent and fluctuating current assets.
b) A business pursuing a conservative policy will have large levels of ready cash and safety inventory and use long-term funding for both non-current and most current assets. This is the least risky option but results in the lowest expected return.
Working Capital Cycle/Cash Cycle/Operating Cycle/Trading Cycle
Working Capital Cycle is the period of time which elapses between the point at which cash begins expended on the production of a product and the collection of cash from a purchaser.
Method 1: The working cycle in a manufacturing business equals:
- Task 2: Wines Co buys raw materials from suppliers that allows Wines 2.5 months credit. The raw materials remain in inventory for 1 month, and it takes Wines 2 months to produce the goods. The goods are sold within a couple of days of production being completed and customers take on average 1.5 months to pay.
Calculate Wines’ working capital cycle
Months
The average time that raw materials remain in inventory
Less: time taken to pay suppliers
The time taken to produce the goods
The time taken by customers to pay for the goods
Method 2: Alternative way to calculate the Working Capital Cycle with ratio analysis
Task 3: From the following data, work out the working capital cycle of A business for years 1 and 2 and discuss the implications of your figures.
Profit and Loss account for years 1 and 2
Task 4: The table below gives data from the accounts of A Co plc for the past three years.
What is the working capital cycle for each year? How might the cycle be reduced and what are the possible disadvantages of doing so?
Managing the Cycle
A longer working capital cycle requires more financial resource, so management will seek whenever possible to reduce the length of the cycle. Their possible options are as follows:
1. Reduce levels of raw materials inventory. May be done through the introduction of some type of JIT system which will necessitate more efficient links with suppliers. Production delays due to running out of inventory must be avoided.
2. Reduce WIP by reducing production volume or improving techniques and efficiency
3. Reduce finished goods inventory perhaps by improving distribution. This may lead to delays in fulfilling customer orders
4. Delay payments to suppliers – can lead to loss of discounts and of supplier goodwill
5. Reduce period of credit given to customers – this may mean offering discounts and more aggressive credit control may lead to a loss of customers.
What is working capital?
Working capital management
Cash forecasts
Cash forecasting ensures that sufficient funds will be available when they are needed to sustain the activities of an enterprise. A cash budget is a detailed budget of estimated cash inflows and outflows, incorporating both revenue and capital items. It is formally adopted as part of the business plan or master budget for the period.
It is often said that in business “Cash is King”, this is said because cash is all-important to businesses. Without cash employees cannot be paid, suppliers cannot be paid, and therefore the business will grind to a halt. Cash is the oil in the machine of business, and a Cash Flow Statement tells us how much cash is or will be available within the business or how much cash will be needed to keep the business running.
Remember that, “A Cash Flow Statement tells us how much cash is or will be available in a business or how much cash will be needed to keep the business running”.
Task 5: Main sources of cash inflows and cash outflows
Which variables could appear on the Profit & Loss account and so affect profit?
Introduction to the cash flow forecast
Causes of cash flow problems
Preparing Cash Budgets
1. Format for cash budgets
a) A clear distinction between the cash receipts and cash payments for each control period. It should be logically arranged with a subtotal for receipts and a subtotal for payments
b) A figure for the net cash flow for each period. Managers find in practice that a figure for the net cash flow helps to draw attention to the cash flow implications of their actions during the period.
c) The closing cash balance for each control period. The closing balance for each period will be the opening balance for the following period.
2. Depreciation is not included in cash budgets
3. Allowance must be made for bad and doubtful debts
Task 6: Illustration
Watson Ltd is preparing budgets for the next quarter. The following information has been prepared so far:
Other information
● Watson sells 10% of its goods for cash. The remainder of customers receive one month’s credit
● Payments to material suppliers are made in the month following purchase
● Wages are paid as they are incurred
● Watson takes one month’s credit on all overheads
● Production overheads are $3200 per month
● Selling, distribution and administration overheads amount to $1890 per month
● Included in the amounts for overheads given above are depreciation charges of $300 (production) and $190 (selling, distribution and administration) respectively
● Watson expects to purchase a delivery vehicle in August for a cash payment of $9870
● The cash balance at the end of June is forecast to be $1235
Prepare a cash budget for July to September inclusive
Watson Ltd cash budget for July to September
Task 7: Cash Flow Forecasts
A Co. Ltd has budgeted for the following sales
April - 10000
May - 12000
June - 12000
July - 13000
August - 16000
September - 16000
● 10% of sales are for cash with the balance on credit requiring payment by the last day of the month following month of invoice.
● Purchases are budgeted at $9000 per month with payment at the end of the second month following month of invoice.
● Wages are budgeted at $3000 per month and general expenses at $2000 per month.
● Bank interest of $1500 will be paid in June
● Plant and machinery costing $10000 will be bought and paid for in August
● The present cash position shows an overdrawn balance at the bank of $4000 at the end of March (the account is in deficit)
Draw up a cash budget for the period April to September inclusive
Task 8: You are presented with the following budgeted data for your organisation for the period November 2012 to June 2013.
● Sales are 40% cash, 60% credit. Credit sales are paid two months after the month of sales
● Purchases are paid the month following purchase
● 75% of wages are paid in the current month and 25% the following month
● Overheads are paid the month after they are incurred
● Dividends are paid three months after they are declared
● Capital expenditure is paid two months after it is incurred
● The opening cash balance on 1 January 2002 is $15000
The managing director is pleased with the above figures as they show sales will have increased by more than 100% in the period under review. In order to achieve this, he has arranged a bank overdraft with a ceiling of $50000 to accommodate the increased inventory levels and wage bill for overtime worked.
(a) Construct a cash flow statement for the period January 2013 to June 2013
(b) Comment upon your results in the light of the managing director’s comments and offer advice
Task 9: Superfix operates a 24-hour repair and maintenance service for photocopying machines. The company, which was set up 3 years ago, employs four people and is based in Ealing, West London. It relies mainly on emergency calls from customers who obtain Superfix’s number from Yellow Pages when their machines malfunction. At the moment the company faces two main problems. First it can struggle to receive payment from customers after work has been carried out. Indeed, bad debts are common for Superfix. Second, it faces quite high labour costs because its staff is not gainfully employed because there are no calls. The managing director of Superfix is about to draw up the cash flow forecast statement for the next trading year. The monthly sales revenue figures are as follows:
The expenses are as follows:
❑ Wages are expected to be $4000 per month
❑ Motor Expenses are expected to be $650 per month
❑ Telephone charges are expected to be $150 (March); $150 (June) $170 (September) and $170 (December)
❑ Insurance is $450 and paid in July
❑ Accountancy fees are expected to be $700 and will be paid in December.
❑ Advertising is paid twice a year in February and August approximately $300 each time.
❑ An allowance of $200 per month is made for miscellaneous expenditure.
❑ Drawings of $1000 per month will be made by the managing director.
❑ Annual ground rent of $4000 is payable in June.
❑ The opening cash balance for Superfix is $850.
(a) Produce a cash flow forecast for Superfix
After analyzing the statement, the managing director decides that something positive must be done to improve the company’s position. It is decided that Superfix will launch an insurance scheme, which will be sold by a specialist salesperson directly to users. For an annual fee the insurance scheme will provide annual maintenance and free callout and labour charges for emergency calls. As a result of this scheme a number of additional cash inflows and outflows are to be expected.
❑ A new salesperson will be recruited at the start of April at a cost of $1500 per month, for the rest of the year.
❑ Extra revenue will be generated resulting from the sale of insurance policies (May $1000; June $1500; July $2000; August $2500; September $3000; October $3100; November $3200 and December $3300)
❑ Motor Expenses will rise by $150 per month from 1st of April onwards.
(b) Produce an amended cash flow statement
REASONS FOR PREPARING CASH FLOW FORECASTS
(1) Identifying the timing of cash shortages and surpluses
If there is a projected shortage then this is a good time to borrow funds. If there is a projected surplus, then it is a good time to plan the purchase of machinery and equipment.
(2) Supporting applications for funding
When trying to raise finance, lenders often insist that businesses support their applications with documents showing business performance.
(3) Enhancing the planning process
Helps to clarify aims and improve performance.
(4) Monitoring Cash Flow
At the end of the financial year the forecast is measured against the actual statement to detect any significant variance in figures. From this you can identify areas of concern, and plan ways to rectify them.
Four possible cash positions
The following strategies for dealing with cash flow problems: reducing cash outflows, improving cash inflows & seeking additional finance
Cash flow problems
● Making losses: continual losses will eventually mean problems whose timing depends on the size of losses and whether depreciation is significant
● Inflation: ever-increasing cash flows required just to replace used-up and worn-out assets
● Growth: business needs to support more receivables and inventory
● Seasonality: difficulties may occur at certain times when cash inflows are low and outflows high.
● Once-off expenditure: large items such as a loan repayment or purchase of expensive non-current asset such as freehold land
● Poor credit control procedures: long average time for credit customers to pay may cause problems
The following are the general strategies for dealing with cash flow problems:
1. Reduce cash outflows
2. Improving cash inflows
3. Looking for additional sources of finance
Methods of easing cash shortages
1. Improving the business: cash deficits can arise out of basic trading factors underlying the business such as falling sales or increasing costs. Clearly, the way to deal with these items is to take normal business measures, rectifying the fall in sales by marketing activities, or if this cannot be achieved, by cutting costs
2. Controlling the operating cycle: short-term deficiencies: cash deficits can also arise out of the business’ management of the operating cycle and from timing differences. The following are possibilities:
a) Borrowing from the bank. This is only a short-term measure. It is possible that a bank will convert an overdraft into a long-term loan, or perhaps new overdraft limits can be set up.
b) Raising Capital: this is likely to be expensive and should be generally used for long-term investment, not short-term cash management.
c) Different sources of finance (such as leasing) might be used
3. When a company cannot obtain resources from any other source such as a loan or an increased overdraft, it take the following steps:
a) Postponing capital expenditure: it might be imprudent to postpone expenditure on non-current assets which are needed for the development and growth of the business. On the other hand, some capital expenditures might be postponable without serious consequences. If a company’s policy is to replace company cars every two years, it may decide, if cash is short, to replace the cars every three years.
b) Accelerating cash inflows which would otherwise be expected in a later period: the most obvious way of bringing forward cash inflows would be to press receivables for earlier payment (leading and lagging receivables)
c) Reversing past investment decisions by selling assets previously acquired
d) Negotiating a reduction in cash outflows so as to postpone or even reduce payments: there are several ways this could be done.
- Longer credit might be taken from suppliers (leading and lagging payables)
- Loan repayments could be rescheduled by agreement with a bank
- A deferral of the payment of tax could be agreed with the taxation authorities
- Dividend payments could be reduced. Dividend payments are discretionary cash outflows, although a company’s directors might be constrained by shareholders’ expectations
- Inventory levels could decrease to reduce the amount of money tied up in their production cost.
Relationship between investment, cash flow and profit
Capital budgeting is the process of choosing investments and assets for long-term business development. A capital budget is made up of a mix of old and new projects and products. The relationship between a company’s cash flow and capital budgeting typically begins with the business’s reliance on capital budgeting to supply it with an inflow of cash. The most significant connection happens when measuring the profitability of items in a capital budget, because business financers use cash flows instead of accounting profits in the calculations.
Since so much of a company’s financial health and perceived stability is based on accounting records, especially profits, some people may wonder why capital budgeting would be based on cash flows. For one, most American accounting is done on an accrual basis, which means that some profits and expenses are not factored into the finances until the end of the company’s accounting cycle. Calculating with cash flows offers a way to evaluate a capital budget in real time.
Use the following graphic to help you determine why investment, cash flow position and profit trend a certain way across the stages of the PLC
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3.7.Cash Flow.docxControlling cash flow for business growth.pdfcash flow forecast.pdf